A Capital Question: Can Japan Compete?

For many years, Japanese companies have felt themselves immune to these pressures. Simply put, they believed they would not have to compete for global capital since they had so much of it at home with their own corporate groupings.

But as it turns out, that entire approach is one of the key reasons why Japan's economy has been stagnant for a decade. Indeed, Japanese companies — which were once among the world's most valuable — are dropping off the radar screens of international investors. That does not bode well for Japan's future.

Indeed, this represents a sea of change from the days when other major economies protested what they saw as a Japanese attempt to snatch up some of those countries' key cultural and financial institutions. Now, it is Japan's cultural warriors who are crying foul.

To a large extent, this situation arose because Japanese companies lived a life protected form the need to compete for capital for the last 30 years.

Initially, close relationships with the so-called main banks provided corporations with the bulk of their capital needs. From the 1970s onward, a small cadre of strategic stakeholders joined in.

Back in 1987, the proportion of total outstanding shares that were owned by such friendly (stable) shareholders had reached a staggering 45.8%. In other words, roughly half of the stated market capitalization of Japan's equity market was squirreled away safely with shareholders that would never sell.

Yet, beginning in the 1980s and then taking full shape in the 1990s, a profound change occurred. These banks — heretofore the de-facto owners of Japan's major corporations — abdicated their role.

Their ballooning pile of bad debts had become so large that the debt and debtors effectively came to "own" the banks. As a result, the banks could not afford to force bankruptcy upon them.

Looking back, the lay of the land prior to 1990 must have seemed like heaven to Japan's corporate management teams. After all, companies' boards of directors consisted almost entirely of corporate managers.

Trusted senior employees were put out to pasture as statutory "auditors." And large blocks of mostly passive and stable shareholders prevented potential takeovers — or even serious opposition — at the annual shareholder meetings.

The last decade has irreparably changed this cozy dynamic. A "big bang" in Japanese accounting has brought accounting standards very close to international accounting standard levels.

By 2005, Japan corporations will be forced to implement "impairment accounting." The non-technical meaning of this concept is that Japanese companies and banks will have to revalue assets on their books — generally at lower levels. That will mean a big hit to their balance sheets.

In anticipation of this blow, companies and banks are selling off assets — including shares of stock that were once never to be sold. The result?

The portion of stocks held by "stable" shareholders has declined — and looks almost certain to continue its descent. No wonder Japan has experienced a 10-year bear market in stocks.

These lower stock prices, in turn, mean that the "capitalization" — or total value of these companies — is also dropping fast. The average listed company now has a market capitalization of JPY210 billion (or $1.6 billion).

Compare this to the average market capitalization for a U.S. company included in the Standard and Poors 500, which stands at $21 billion. Furthermore, the market capitalization of three quarters of the TSE 1 listed companies is a mere JPY90 billion (or $692 million) — which is quite small by international standards.

In fact, most large institutional investors in Japan require companies to have a market capitalization of JPY100 billion (or $769 million) or more for a company to be added to their "investibles" list. As a result, most TSE 1 listed stocks have therefore simply disappeared from the radar screen of large institutional investors.

All this means, of course, is that Japan is no longer even in competition with U.S. or European companies for investor capital. Rather, it is competing with other Asian countries.

Moreover, though the stated market capitalization of the four major Asian stock markets is still only some 30% of Japan's, the annual trading values of these four exchanges are now as large as Japan’s.

Even more ignominiously, the national high-tech champions of Taiwan and South Korea are now larger than the market capitalizations of Japan's high-tech companies.

That is surely a shock to a country that, just 15 years ago, boasted of a company (Nippon Telegraph and Telephone) that had a market capitalization greater than that of the entire German stock market.

But the bad news does not end there. Japanese companies are paying an ever steeper price for their inability to compete for capital — both in terms of their market capitalization and their inability to tap the equity capital markets.

Company by company, Japanese corporations have lost "sell-side" analyst coverage — and thus disappeared from institutional investor portfolios. The remaining shareholders are increasingly restive, expressing their displeasure with negative votes at the annual shareholders meetings.

These companies have effectively lost their protective cocoon of stable shareholders, leaving them susceptible to activist shareholders and takeover attempts.

There are some positive signs, however. Membership in Japan's Investor Relations Association has just reached 500 — up from zero when the association was first inaugurated in 1993.

And yet, the bulk of Japan's corporate managers has still not embraced the need for change. After all, there are over 3,000 listed companies in Japan — all of which have a vested interest to be members of the association.

In a historic context, it is ironic to note that it is now the Japanese who are complaining that foreign capital is buying up key national icons.

The Long-Term Credit Bank of Japan was swallowed up by Ripplewood Holdings — and Nikko Securities was bought by Citibank. Renault zoomed in to snatch up Nissan — and Wal-Mart pulled away Seiyu, the supermarket chain, with a good old fashioned American tractor.

Who knows? By the time the inevitable M&A boom in Japan is finished, Japanese consumers may even be watching U.S.-branded color TVs and driving U.S.-branded cars, which would be the ultimate case of trading places.